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Auditor Warns of Risks From Local Debt in China

SHANGHAI — The head of China’s national audit office warned on Monday that the country was facing growing risks because of a sharp rise in local government debt and poor controls over borrowing by investment companies set up by municipalities, provinces and other bodies.

Liu Jiayi, the top auditor in China, said on Monday that at the end of last year local government debt had reached $1.7 trillion, or about 27 percent of the nation’s gross domestic product. He said better regulation was needed to manage the debt risks.

“The management of some local government financing platforms is irregular, and their profitability and ability to pay their debts is quite weak,” Mr. Liu said in a speech Monday.

The release of the report by the national auditor, who works under China’s cabinet, or State Council, comes as worries are growing that China’s economy is overheating. Beijing is now trying to rein in bank lending to moderate growth and tame inflation and property prices.

Some analysts say an economic slowdown could expose huge hidden liabilities in the banking system. Many of the problems are tied to a $586 billion stimulus package Beijing announced in late 2008 and a huge wave of state-backed lending in 2009 and 2010. Those money infusions were aimed at buffering China from the global financial crisis.

Although many economists argue that the country’s enormous stash of foreign exchange reserves helps make Beijing strong enough to cope with the local government liabilities, they also point to worrisome signs of mounting debt.

The auditor’s report on Monday was similar to a warning earlier this month by the Chinese central bank. The bank said that at the end of last year, local government liabilities were as high as 30 percent of gross domestic product, or about $2.2 trillion — far higher than previous estimates.

That survey said local governments had created 10,000 investment companies to borrow money from banks, mostly to finance ambitious infrastructure projects. (China does not allow local governments to issue bonds to finance projects.)

But the national auditor’s report varied from the central bank’s in saying its survey had counted only about 6,500 local government investment companies. Analysts cited the possibility that that auditor’s survey was not as thorough as the central bank’s.

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Many analysts have grown cautious about China’s economy. Some have reduced growth estimates and downgraded their ratings of Chinese banks over concerns about a coming wave of nonperforming loans associated with local government debt.

Last week, Charlene Chu, an analyst at Fitch, the credit ratings agency, said China’s growth had recently become too reliant on loose credit and that “easy money” was helping fuel inflation and a property bubble, according to a presentation she delivered at a global banking conference in Hong Kong.

She also said there were growing risks because of a shadow banking system that had emerged beyond regulatory scrutiny in China and because of an “overextension” of loans to local governments.

Victor Shih, a professor of political science at Northwestern University in Illinois and one of the first to warn about a sharp rise in local government debt in China, said on Monday that the recent surveys were useful antidotes to local government efforts to keep much of their borrowing secret from Beijing.

“It’s a significant step for them to release these numbers,” he said in a telephone interview. “But I think the problem is much, much bigger.”

Mr. Shih and other analysts say local governments create their own investment companies to borrow from state banks to finance infrastructure projects. And because much of that borrowing is done off official balance sheets, often using government land or assets as collateral, the debt can be hard to track and assess.

And often the projects, which include roads, bridges, tunnels and subway systems, do not generate enough earnings to repay the loans.

In its report Monday, the national audit office said it had found many irregular activities. For instance, many local governments were using “unreal” or illegal collateral to secure the loans, the report said, and some of the money they borrowed was funneled into the stock and property markets. At other times, the auditor said, the local governments were “overestimating the value of the collateral” — which was often tied to land values.

A version of this article appears in print on June 28, 2011, on Page B1 of the New York edition with the headline: Top Auditor In China Says Debt Risks Grow. Order Reprints|Today's Paper|Subscribe